Less cash kept on hand for loan losses last quarter is a barometer of an improving economy.

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It is a good sign when banks start reporting lower loan losses: More borrowers are paying their bills on time, and that typically means the economy is on the mend.

An even better sign is when banks lower the amount of money they set aside for potential losses in the future, because it signals that they think the good times are going to last.

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During the fourth quarter, many banks flashed that good-times indicator.

In Washington, Cascade Financial and Rainier Pacific Financial cut their so-called “provision” for loan losses in half for the latest quarter, compared with the same period a year earlier. Frontier Financial and others have also pared back the amount they set aside for loan losses.

It is a trend that began about two years ago, as banks realized that loans were not likely to sour at the same rate they had feared.

Many banks had set aside extra money after meltdowns at behemoths such as Enron and WorldCom, which stung some of the nation’s largest banks and caused others to worry about a trickle-down effect.

“With 20/20 hindsight, they reserved a lot more than they needed to,” said Craig Woker, senior bank analyst at the investment research firm Morningstar.

Indeed, Catherine Phillips-

Olsen, regional manager for the division of insurance and research at the Federal Deposit Insurance Corp.’s San Francisco office, said the industry began to see improvement in loan portfolios even as the economic downturn continued.

Lower interest rates helped people pay their bills more easily, and many homeowners refinanced their mortgages, creating newer loans which are less likely to have problems, she said.

That’s not to say that loans remained pristine during the hard times.

Frontier Bank in Everett was hammered in 2001 when it had to write off $9.3 million of a bad loan to a heavy equipment dealer.

“In the 22 years prior to that year, probably all of our net charge-offs combined didn’t equal that,” said Frontier CEO John Dickson.

After that spike, charge-offs remained relatively high at Frontier until 2004, when they fell to $328,000.

“Credit quality has improved dramatically, I believe, for all banks,” Dickson said.

As a result, Frontier lowered its provision for loan losses from $4.25 million in 2003 to $3.5 million in 2004.

In the fourth quarter, Cascade Financial in Everett cut its loan-loss provision to $150,000 compared with $300,000 in the same quarter a year ago.

Rainier Pacific in Tacoma also reduced its provision for loan losses by half, to $600,000 in the fourth quarter of 2004 from $1.2 million a year earlier.

The trend is happening nationally, with preliminary results showing that in the fourth quarter, loan quality at the nation’s banks continued to improve, Phillips-Olsen at the FDIC said.

During the third quarter of 2004, the industry’s ratio of reserves to total loans fell to 1.4 percent, its lowest level since the third quarter of 1986.

Washington Mutual in late 2003 took $120 million out of loan-loss reserves because of the improving economy. It took another $82 million out because it had sold a large loan portfolio.

Partly because WaMu’s loans lean heavily toward consumers, it was ahead of the trend in reducing its cushion for loan losses. Banks with stronger focus on commercial lending have been more cautious, although they, too, are pulling back the amounts they reserve.

The third quarter of 2004 marked the seventh quarter in a row that the industry’s net charge-offs exceeded the amount institutions set aside for losses, an indication that they expect fewer problem loans going forward. Fourth-quarter figures for the industry are not yet available.

When it comes to credit quality, said Dickson at Frontier, “I’ve heard people say we’re almost at nirvana, and it can’t get much better.”

Melissa Allison: 206-464-3312 or mallison@seattletimes.com